On the Unsustainability of Austrian Business-Cycle Theory, Or How I Discovered that Ludwig von Mises Actually Rejected His Own Theory

Robert Murphy, a clever fellow with an excessive, but, to his credit, not entirely uncritical (see here and here), devotion to Austrian Business Cycle Theory (ABCT), criticized my previous post about ABCT. Murphy’s criticism focuses on my alleged misreading or misrepresentation of Mises’s original version of ABCT in his The Theory of Money and Credit. (Note, however, that we are both dealing with the 1934 translation of the revised 1924 edition, not the original 1912 German text.)

Murphy quotes the following passage from my post focusing especially on the part in bold print.

[T]he notion of unsustainability [in Austrian business cycle theory] is itself unsustainable, or at the very least greatly exaggerated and misleading. Why must the credit expansion that produced the interest-rate distortion or the price bubble come to an end? Well, if one goes back to the original sources for the Austrian theory, namely Mises’s 1912 book The Theory of Money and Credit and Hayek’s 1929 book Monetary Theory and the Trade Cycle, one finds that the effective cause of the contraction of credit is not a physical constraint on the availability of resources with which to complete the investments and support lengthened production processes, but the willingness of the central bank to tolerate a decline in its gold holdings. It is quite a stretch to equate the demand of the central bank for a certain level of gold reserves with a barrier that renders the completion of investment projects and the operation of lengthened production processes impossible, which is how Austrian writers, fond of telling stories about what happens when someone tries to build a house without having the materials required for its completion, try to explain what “unsustainability” means.

The original Austrian theory of the business cycle was thus a theory specific to the historical conditions associated with classical gold standard.

Murphy then chastises me for not having read or having forgotten the following statement by von Mises.

Painful consideration of the question whether fiduciary media really could be indefinitely augmented without awakening the mistrust of the public would be not only supererogatory, but otiose.

Now it’s true that I did not recall this particular passage when writing my post, but the passage is not inconsistent with the point I was making. If you look at the passage from section 4 of chapter 5 of Part III of The Theory of Money and Credit (p. 357 of the 1934 edition), you will see that the context in which the statement is written is a hypothetical example in which banks can engage in an unlimited credit expansion without the constraints of an internal or external drain on their balance sheets. So while it is true that Mises anticipated in The Theory of Money and Credit the question whether a banking system not constrained by any internal or external drains could engage in an unlimited credit expansion, Mises was engaged in a hypothetical exercise, not the analysis of any business cycle ever encountered.

Murphy provides two longer quotations from a bit later in the same chapter in which Mises tried to explain why an unlimited credit expansion would be unsustainable:

The situation is as follows: despite the fact that there has been no increase of intermediate products and there is no possibility of lengthening the average period of production, a rate of interest is established in the loan market which corresponds to a longer period of production; and so, although it is in the last resort inadmissible and impracticable, a lengthening of the period of production promises for the time to be profitable. But there cannot be the slightest doubt as to where this will lead. A time must necessarily come when the means of subsistence available for consumption are all used up although the capital goods employed in production have not yet been transformed into consumption goods. This time must come all the more quickly inasmuch as the fall in the rate of interest weakens the motive for saving and so slows up the rate of accumulation of capital. The means of subsistence will prove insufficient to maintain the labourers during the whole period of the process of production that has been entered upon. Since production and consumption are continuous, so that every day new processes of production are started upon and others completed, this situation does not imperil human existence by suddenly manifesting itself as a complete lack of consumption goods; it is merely expressed in a reduction of the quantity of goods available for consumption and a consequent restriction of consumption. The market prices of consumption goods rise and those of production goods fall. (p. 362)

And

If our doctrine of crises is to be applied to more recent history, then it must be observed that the banks have never gone as far as they might in extending credit and expanding the issue of fiduciary media. They have always left off long before reaching this limit, whether because of growing uneasiness on their own part and on the part of all those who had not forgotten the earlier crises, or whether because they had to defer to legislative regulations concerning the maximum circulation of fiduciary media. And so the crises broke out before they need have broken out. It is only in this sense that we can interpret the statement that it is apparently true after all to say that restriction of loans is the cause of economic crises, or at least their immediate impulse; that if the banks would only go on reducing the rate of interest on loans they could continue to postpone the collapse of the market. If the stress is laid upon the word postpone, then this line of argument can be assented to without more ado. Certainly, the banks would be able to postpone the collapse; but nevertheless, as has been shown, the moment must eventually come when no further extension of the circulation of fiduciary media is possible. Then the catastrophe occurs, and its consequences are the worse. (p. 365)

The latter quotation actually confirms my assertion that Mises’s theory of business cycles as a historical phenomenon was a theory of the effects a credit expansion brought to a close by an external constraint imposed on the banks by the gold standard or perhaps by some artificial legal constraint on the reserve holdings of the banks. It is true that Mises hypothesized that a credit expansion by a completely unconstrained banking system was inevitably destined to be unsustainable, but this is a purely theoretical argument disconnected from historical experience.

But that is just what I said in my post:

[D]espite their antipathy to proposals for easing the constraints of the gold standard on individual central banks, Mises and Hayek never succeeded in explaining why a central-bank expansion necessarily had to be stopped. Rather than provide such an explanation they instead made a different argument, which was that the stimulative effect of a central-bank expansion would wear off once economic agents became aware of its effects and began to anticipate its continuation. This was a fine argument, anticipating the argument of Milton Friedman and Edward Phelps in the late 1960s by about 30 or 40 years. But that was an argument that the effects of central-bank expansion would tend to diminish over time as its effects were anticipated. It was not an argument that the expansion was unsustainable.

So let’s go back to what Mises said in the middle quotation above, where he tries to do the heavy lifting.

[D]espite the fact that there has been no increase of intermediate products and there is no possibility of lengthening the average period of production, a rate of interest is established in the loan market which corresponds to a longer period of production; and so, although it is in the last resort inadmissible and impracticable, a lengthening of the period of production promises for the time to be profitable.

I don’t understand why there has been no increase in intermediate products. The initial monetary expansion causes output to increase temporarily, allowing the amount of intermediate products to increase, and the average period of production to lengthen.

But there cannot be the slightest doubt as to where this will lead.

Note the characteristic Misesian rhetorical strategy: proof by assertion. There cannot be the slightest doubt that I am right and you are wrong. QED. Praxeology in action!

A time must necessarily come when the means of subsistence available for consumption are all used up although the capital goods employed in production have not yet been transformed into consumption goods.

Are the means of subsistence a common property resource? When property rights don’t exist over resources, those resources run out. The means of subsistence are owned and they are sold, not given away or taken at will. As their supply dwindles, their prices rise and consumption is restricted.

This time must come all the more quickly inasmuch as the fall in the rate of interest weakens the motive for saving and so slows up the rate of accumulation of capital.

But the whole point is that monetary expansion is raising the prices of consumption goods thereby imposing forced saving on households to accommodate the additional investment.

The means of subsistence will prove insufficient to maintain the labourers during the whole period of the process of production that has been entered upon.

What does this mean? Are workers dying of starvation? Is Mises working with a Ricardian subsistence theory of wages? But wait; let’s read on.

Since production and consumption are continuous, so that every day new processes of production are started upon and others completed, this situation does not imperil human existence by suddenly manifesting itself as a complete lack of consumption goods; it is merely expressed in a reduction of the quantity of goods available for consumption and a consequent restriction of consumption. The market prices of consumption goods rise and those of production goods fall.

OK, so what is the point? What is unsustainable about this?

Now I am really confused. But wait! Look at the preceding paragraph, and read the following:

Now it is true that an increase of fiduciary media brings about a redistribution of wealth in the course of its effects on the objective exchange value of money which may well lead to increased saving and a reduction of the standard of living. A depreciation of money, when metallic money is employed, may also lead directly to an increase in the stock of goods in that it entails a diversion of some metal from monetary to industrial uses. So far as these factors enter into consideration, an increase of fiduciary media does cause a diminution of even the natural rate of interest, as we could show if it were necessary. But the case that we have to investigate is a different one. We are not concerned with a reduction in the natural rate of interest brought about by an increase in the issue of fiduciary media, but with a reduction below this rate in the money rate charged by the banks, inaugurated by the credit-issuing banks and necessarily followed by the rest of the loan market. The power of the banks to do such a thing has already been demonstrated. (pp. 361-62)

So von Mises actually conceded that monetary expansion by the banks could reduce the real rate of interest via the imposition of forced savings caused by a steady rate of inflation. Unsustainability results only when the central bank reduces the rate of interest below the natural rate and succeeds in keeping it permanently below the natural rate. The result is hyperinflation, which almost everyone agrees is unsustainable. We don’t need ABCT to teach us that! But the question that I and most non-Austrian economists are interested in is whether there is anything unsustainable about a steady rate of monetary expansion associated with a steady rate of growth in NGDP. Answer: not obviously. And, evidently, even the great Ludwig von Mises, himself, admitted that a steady monetary expansion is indeed sustainable. You can look it up.

67 Responses to “On the Unsustainability of Austrian Business-Cycle Theory, Or How I Discovered that Ludwig von Mises Actually Rejected His Own Theory”

Another one knocked right out of the park. But the ABCT has many lives, so beware!

For what it’s worth, I think Tyler Cowen did a good job of rescuing the better elements of ABCT along more modern, Fischer Black-influenced lines in his ’97 book Risk & Business Cycles. Unfortunately, he looks at the data and the empirical record, which immediately makes him unpalatable to the Misesian tradition.

David, you say that Mises’s discussion of a completely unconstrained credit expansion was merely hypothetical and disconnected from historical experience. But Mises, at least by the time he wrote the 1924 version, had just lived through some terrific changes in central banking practice during the war and several hyperinflations after it. Surely his was more than just a hypothesis, but an effort to grapple with these historical events.

For instance, here is Mises near the end of ToMaC. He doesn’t seem to think that he is dealing with hypothetical events.

“Before the War, State control of banking was desired with the very object of artificially depressing the domestic rate of interest below the level that considerations of the possibility of redemption would have dictated if the banks had been completely free. The attempt was made to render as nugatory as possible the obligations of cash redemption, which constitutes the foundation stone of all credit-issuing bank systems. This was the intention of all the little expedients, individually unimportant but cumulatively of definite if temporary effect, which it was then customary to call banking policy. Their one intent may be summed up in the sentence: By hook or by crook to keep the rate of discount down. They have achieved the circumvention of all the natural and legal obstacles that hinder the reduction of the bank rate below the natural rate of interest. In fact, the object of all banking policy has been to escape the necessity for discount policy, an object, it is true, which it was unable to achieve until the outbreak of the War left the way free for inflation.”

In any case, I agree with the rest of your post and am curious to see what Bob Murphy has to say.

I confess, I’m not going to try to sort out where I think Bob is right and where wrong and so on. And I do think the difference between ABCT and the monetary disequilibrium theory have been exaggerated by many of us in the “Austrian” group. Steve Horwitz’s 2001 book is good on this subject IMHO. Nevertheless, an Austrian approach can give you a couple of things that do not fall out so naturally from a more or less “monetarist” framework.

First, there is the fact that monetary expansion does not necessarily imply price inflation. I think we are probably all more comfortable with that idea now because we are familiar with the claim that a deviation from the Taylor rule created (or helped to create) a false boom. But before 2008, lots of people would have found the idea pretty hard to understand.

Second, there is distortion to the structure of production. It think we should just talk about more and less interest sensitive sectors. As far as I can tell, more elaborate notions of the time structure of production don’t do any real work within the Austrian cycle theory. However all that may be, the Austrians have a good story about why the cycle wastes resources quite apart from the bust period of unemployed resources. I think it’s harder pull that lesson out from other monetary theories of the trade cycle.

Third, in an Austrian story the boom is doomed. That is, the bust is not merely a consequence of a contraction of the money supply relative to trend. Even before that happens, you have ensured that bust will happen when you expanded the money supply and launched the boom. Here again, the recent crisis makes that argument understandable, but before 2008 it was puzzling to many economists.

I think you are right to say (if I understood you) that Mises and Hayek were assuming a commodity standard in which the money supply more or less had to snap back at some point. So it may often have been true that the the proximate cause of the downturn is a contraction of the money supply relative to trend. IMHO: Yes. But the Austrians do have an argument that shows, I think, that a bust would eventually set in even if you assume away the monetary snap back. But once you get the bust induced without the monetary snap back, you had better recognize that the money supply will now fall relative to trend if only because of the banks’ need for higher reserve ratios given the increased rate of loan defaults. Modern Austrians have, I think, tended to emphasize this real path and neglect the more obvious possibility of a monetary snap back. I think that’s a fair criticism. I would even say, as you might, that in a world of fiat money the proximate cause of the bust may well be a contraction of the money supply relative to trend. If the central bank will act to hold off hyperinflation, then the bust may come from a failure of money supply growth to rise fast enough rather than the still-latent real factors noted earlier. Sure. Why not? Again, we Austrians have probably exaggerated the differences between the Austrian approach and more monetarist stories, especially the monetary disequilibrium theory.

“So von Mises actually conceded that monetary expansion by the banks could reduce the real rate of interest via the imposition of forced savings caused by a steady rate of inflation. Unsustainability results only when the central bank reduces the rate of interest below the natural rate and succeeds in keeping it permanently below the natural rate. The result is hyperinflation, which almost everyone agrees is unsustainable. We don’t need ABCT to teach us that!”

David, there is some serious misunderstanding here, as there is in your previous post. I plan to make a detailed response, but for the moment: (1) “forced saving” is the counterpart of below-natural interest rates, and as such is itself unsustainable; (2) it needn’t involve steady inflation (in the sense of a steady rise in output prices); it does require that the equilibrium level of input prices is rising, but equilibrium output prices may be steady or even falling if productivity if improving–in fact forced savings are simply the short-run consequence of excessive nominal income growth; (3) the unsustainabiity of the boom does not require a slowing down, let alone a reversal, of the rate of nominal income growth or credit expansion; it happens because eventually the nominal demand schedule for loanable funds, which is itself conditional on the prices of inputs and durable goods, rises just as much as the nominal supply, forcing actual interest rates back to their natural levels; (4) what Mises said was not that the boom is only unsustainable if you have hyperinflation; he said that, because of the tendency I just described, were it to try and sustain the boom a central bank would have to make credit grow at an accelerating pace, so as to keep a step ahead of input price (and credit demand) adjustments, but that this would eventually lead to hyperinflation. It’s a simple point based on the assumption of elastic expectations. The point is that booms based on below-natural interest rates are never sustainable–that they must eventually end whatever policies the CB pursues, hyperinflation being only the most drastic result that might follow from CB attempts to avoid the inevitable.

It’s true that some Austrians themselves have suggested, wrongly, that the boom only ends if the CB reverses course–as it might have to do under a gold standard. But Mises hyperinflation point was precisely aimed at the case were there is no gold constraint.

Anyone familiar with Wicksell’s theory, upon which Mises’s cycle theory is based, should understand the argument that, while it is possible for monetary policy to temporarily cause a divergence of interest rates from their “natural” levels, those results only hold for as long as it takes excess money demand or supply to be fully equilibrated by corresponding price adjustments. To go from here to unsustainable real activity is just a matter of recognizing that interest rates are relative prices, and that people may confuse unanticipated but unsustainable changes in these signals with sustainable ones. One may deny that the effects are important ones, but to reject the theory on a priori grounds you would have to throw out a lot more than Mises, including Cantillon, Thornton, Wicksell, and a heap of orthodox price theory.

Finally, it’s quite incorrect to assume that to assert that there’s merit to the Austrian view is to deny that busts can also be caused by monetary contraction–as if the Fed and other CB’s weren’t capable both of encouraging booms with overly easy money and of contributing to busts by making money overly tight. A man is rescued from drowning, his lungs full of water. He is revived, but then given nothing to drink. Must we say of such a man either that he is suffering from having taken in too much water, or that he is suffering from taking in too little? Can we not say that he has suffered first from one thing and then from the other?

Similarly, is it not possible for one to suggest that there was too much credit expansion in the U.S. from 1924 to 1928, and too little afterwards, or that there was too much from 2003-2006 and too little afterwards? If it is possible, then I wonder why so many critics of the Austrian theory here and on other posts have insisted on treating those like myself who suggest it may capture some aspect of the recent cycle as also denying that the post 2007 contraction of nominal spending was anything but a desirable “corrective” response to previous malinvestment?

The suggestion that Austrian and MM views are irreconcilable is in fact deeply mistaken. Heck: Hayek himself clearly stated that stable MV was what was needed. For my part, I happily concede that deficient MV growth after 2007 caused a crisis far more severe that what might be attributed to the mere ending of an unsustainable boom–what’s more, I never suggested otherwise.

Nor, finally, did I ever suggest, as you and some others have implied, that Fed policy was alone responsible for the housing boom. I’m not inclined toward such reductionist thinking. I merely claim that it was one of many factors.

In short, it simply won’t do to dismiss ABCT because it fails to explain why credit-driven booms can’t be sustained in a fiat-money world, because it’s clear that contractions like that of the early 1930s and post 2007 coincided with massive reductions in nominal spending, or because Fannie and Freddy and rating agencies and greed mortgage companies and so on clearly played a part in the housing bubble. The Austrian theory may account for only a small part of the story–I recognized as much in closing my post (though the point seems to have been overlooked). But the claim that the Austrian theory of unsustainable booms is simply irrelevant is itself…unsustainable.

1. It looks at the value of the liability (debt) and the value of the good produced without factoring in value added. For example, ABCT tries to limit the value of a good as the cost of the inputs (material, labor, capital).

ABCT forgets that part of the value of the end product also includes its utilitarian (for instance a motorized vehicle) and ephemeral values (for instance a rare painting or sculpture).

2. It assumes that debt is the only means of financing production available (as if the equity markets did not exist). And while an individual home builder probably does not have equity financing available, a company that builds premanufactured homes may indeed.

Mr. Restly might at least try to draw some connection between his observations and the theory that he imagines them to refute. So far as I am aware, there isn’t any. What’s more, the claims he makes themselves appear quite unfounded: nothing could be more absurd than to accuse the Austrian economists of assuming that value depends on cost of inputs, or of ignoring the role of utility, scarcity, and “ephemeral” preferences. And where does the theory rely on the assumption that there’s no equity market?

ABCT reminds me of the gold standard: some people are so anxious to declare their opposition to it that they don’t mind doing so in a manner that suggests that they know next to nothing about it.

what Mises said was not that the boom is only unsustainable if you have hyperinflation; he said that, because of the tendency I just described, were it to try and sustain the boom a central bank would have to make credit grow at an accelerating pace, so as to keep a step ahead of input price (and credit demand) adjustments, but that this would eventually lead to hyperinflation.

This is an apt description of the key issue. In nominal terms that is.

In real terms, the reason why the central banking system has to continue to accelerate credit so as to prevent the relative price adjustments described by Selgin, ultimately rests on the physical fact of resource scarcity, which manifests itself in partial relative under-production and over-production of resources that makes such relative price adjustments inevitable.

After all, if resources were infinite, then should the central bank lower interest rates from their “natural” levels, and bring about a partial relative over-production of higher order capital stage resources, there won’t be any accompanying partial relative under-production of other resources. Hence, a heightened rate of credit expansion won’t bring about any negative real effects that would require a further acceleration in credit expansion to prevent those effects from transpiring. The CB would no longer be fighting against scarcity.

The two main lessons that Glasner and other non-Austrians need to understand is 1. Resource scarcity, and 2. Capital structure temporality.

Once these two concepts are understood, and understood well, then one can understand ABCT.

“the unsustainability of the boom does not require a slowing down, let alone a reversal, of the rate of nominal income growth or credit expansion; it happens because eventually the nominal demand schedule for loanable funds, which is itself conditional on the prices of inputs and durable goods, rises just as much as the nominal supply, forcing actual interest rates back to their natural levels”

Perhaps you’ll address this in your more detailed post, but if the underlying assumption is that the central bank keeps its rate at very low levels indefinitely, how can it be forced to bring its rate back up to a more natural level?

JP, the “underlying assumption” begs the question: if the targeted rate is below the natural rate, then the central bank cannot possibly maintain it indefinitely. Suppose the CB sets a below target rate, and at first succeeds at achieving it by means of a more generous policy that shifts out the LF supply schedule (let’s just keep it in static terms for the sake of simplicity–the arguments could be stated in terms of “increasing the rate of LF supply growth” without changing anything). Eventually the new lending borrowing inspired by the lower rates (we have dropped down the initial LF demand schedule) exerts positive pressure on prices, and especially the prices of the very things people buy with borrowed funds. That in turn causes the LF demand schedule to rise. In the long run, the interest rates rises back to its natural level; and the money stock change is otherwise neutral except w.r.t. the general level of prices (which, if productivity is growing, can mean that output prices fall less than they otherwise would have).

Now–and this is Mises’s point–the CB could try to combat the tendency of the interest rate to rise, that is, could try to stick to its (unnaturally low) target, by resorting to further expansion (dynamic equivalent: a faster rate of expansion); but eventually demand schedules, including that for LF, will also start rising that much faster. In a world of adaptive expectations the target rate can be maintained only by ever-accelerating inflation, which of course ultimately means hyperinflation. In ratex world even that strategy cannot succeed as people will learn to anticipate the credit acceleration, and will plan to adjust prices accordingly.

In practice central banks can therefore contribute to booms only for a limited time. That’s just another way of saying that the Austrian perspective is not inconsistent with the usual long-run neutrality propositions. What’s odd is that the Market Monetarists appear here, in their zeal to show that ABCT is “wrong,” to deny those propositions and to insist instead that there’s no reason why central banks can’t set real interest rates as low as they like for as long as they like!

“In the real world, interest rates are not equilibrating the supply of and demand for loanable funds; interest rates emerge out of the process of evaluating all durable assets, which are nothing but claims to either fixed or variable future cash flows of various durations and risk characteristics…”

“Painful consideration of the question whether fiduciary media really could be indefinitely augmented without awakening the mistrust of the public would be not only supererogatory, but otiose”

If Mises is referring only to credit expansion at the discretion of the public, then this statement is pure double talk. How can the public have a mistrust of expanding fiduciary media when the public is demanding that expansion of fiduciary media by borrowing it into existence? Excess borrowing by non-productive entities (like the federal government) is another question entirely.

I mean really, it is up to the borrower to decide how money will be used. You might argue that in a world with a fixed supply of resources, inflation will ultimately take hold with unconstrained credit expansion to which I would counter, that is a choice made by borrowers not by the central bank.

I could chose to borrow money to create an energy to matter converter. You want more gold, fine, give me about a year to harvest enough solar energy and I will produce you some gold. Hence my energy to gold converter is an example of value added through utility – I am able to take something that has some value (solar energy) and convert it to something that has a presumably higher value (gold).

Or I could chose to borrow money to buy the equity of the company that invented the energy to matter converter. Here again, credit (my borrowing) expands to the benefit of the producer.

Also, your statement:

“What’s odd is that the Market Monetarists appear here, in their zeal to show that ABCT is “wrong,” to deny those propositions and to insist instead that there’s no reason why central banks can’t set real interest rates as low as they like for as long as they like!”

First, central banks don’t set real interest rates – they set nominal interest rates. A central bank has absolutely no control on how debt in used. It can be used to produce more than what is consumed – putting downward pressure on prices and it can be used to consume more than what is produced – putting upward pressure on prices.

Second, nominal interest rates are not the only consideration in the supply and demand for goods. Tax policy plays a role. Equity and other means of financing play a role. And just plain old human choice plays a role.

Ritwik, You are right ABCT keeps coming back. I don’t mind that; it’s just the fervor of ABCT acolytes that I find disconcerting. Nice baseball metaphor, and well-timed just as the playoffs are underway. Very impressive. I must admit that I have never read Tyler’s book. Will have to put that on my reading list.

JP, You are a careful reader, and make a good point. However, the central banking practice in the decade after the first edition of Mises’s book was largely the result of war-finance considerations. I don’t think that it would be fair to say that the war-time credit expansion gave rise to an investment boom or a lengthening of the period of production. So I wouldn’t consider the inflationary experience of World War I particularly relevant to the Austrian theory.

Roger, Good to hear from you. I spend a lot of time being critical of ABCT, because of its cultish aspects which I find highly objectionable for reasons that are not strictly economic. So I agree with you that Austrian economics has a lot going for it, but it is way, way oversold by ABCT crowd, especially the ones who take Murray Rothbard seriously.

Your third point is the one that I am challenging. A steady-state monetary expansion may give rise to a readjustment once it becomes fully anticipated, but it implies more or less the same equilibrium time path as that implied by a zero expansion steady state. And my quotation from Mises shows that he essentially conceded the point. That a constantly accelerating monetary expansion is not sustainable is a proposition not unique to Austrian theory, as almost all monetary theorists, including Keynes of the Tract on Monetary Reform, agreed.

George, I agree that forced saving is the product of a below-natural real rate of interest. However, the Austrian unsustainability argument involves a claim that there will not be enough resources available to complete production processes or investments that have been started. My point is that role of the price mechanism is to allocate scarce resources to their highest valued use, so given the previous investment decisions why doesn’t the price mechanism allow resources to be allocated in a way that allows the half-finished, or three-quarters resources to be completed rather than be completely abandoned. Although forced saving is triggered by a below-natural real rate, the effects on consumption of the below-natural real rate may not cease immediately when the real rate is now longer less than the natural rate.

My reading of Austrian business-cycle theory, in general, and, until last night as I was writing this post, of Mises, in particular, was that a monetary expansion at even a constant rate is unsustainable. If you say that that is not a proposition of ABCT, I am happy to hear that, but how would you square that with the Austrian theory of the Great Depression. Am I supposed to believe that not only were the 1920s a period of inflation, but a period of accelerating inflation? If the 1920s were not a period of accelerating inflation, please explain to me what was unsustainable about the so-called inflationary boom of the 1920s. I would also like to know, under this interpretation of ABCT, what distinguishes ABCT from Friedman’s natural rate of unemployment model? I agree that Mises and Hayek anticipated Friedman’s discussion by a good three or four decades, but what is the value added of the Austrian capital theory if you get the same basic result out of either approach. Or let me put it to you another way, as the author of the fine book Less than Zero. What is the cyclical advantage of a secularly falling price level that you call for, if it is only accelerating inflation that is unsustainable?

There’s actually not that much that I would disagree with in your comment. I guess the most significant point of disagreement would be that I attach very little empirical significance to whatever minimal distortions were induced by a supposedly too rapid rate of monetary expansion from 1924 to 1928, and would assign almost all the causal significance to the monetary contraction that began with a vengeance (and was cheered on by Mises and Hayek) in 1928.

Frank, I don’t think there’s any basis for saying that Austrian view the value of anything as being constrained by the costs of inputs. In fact, it is precisely the opposite. Austrian theory emphasizes more than almost any other branch of neoclassical economics that it is value that determines cost (cost being simply foregone values of alternatives) not cost that determines value. As for the neglect of equity financing, I will let others respond, but I will just note that the first book written (in German and to my knowledge never translated) by the remarkably prolific and insightful economist Fritz Machlup was an analysis of the role of the stock market in the trade cycle. Machlup was something of a renegade Austrian who was held in contempt by his former teacher the implacable Ludwig von Mises for his apostasy. But he wrote that first book while he was still under Mises’s tutelage and an Austrian in good standing.

“How can the public have a mistrust of expanding fiduciary media when the public is demanding that expansion of fiduciary media by borrowing it into existence?”

This is really too much: even in hyperinflations someone “demands the expansion” of the money stock in the crude sense that someone accepts the money that’s placed into circulation, whether by lending or by means of helicopter drops. But such “demand” isn’t the same as demand for real balances; and its presence in no way precludes “the public” from being capable, all the while that it “accepts” new money, from fearing the consequences of too much of it being created!

Indeed, I see nothing at all wrong with Mises’ statement, however much one may or may not like his way of putting things. What I do see is a desire to bash Mises’ with any old stick. Having had my own run ins with extreme Misesians, I recognize as well as anyone how truculent and foolish they can be. But those who suggest here that Mises was just a sloppy thinker when it came to monetary economics are I think just as much in the worng, though at the other extreme. That there are obnoxious ABCT acolytes is no reason to go out of one’s way to dismiss the theory and its original authors as if they themselves were no better.

And no, JP, the CB can’t ignore the demand for loanable funds in attempting to keep nominal rates at arbitrarily low levels by means of more aggresive monetary expansion!. (Note: by picking the right rate of deflation they can target any nominal rate–but that’s not the same thing!) There is such a thing as Wicksellian indeterminacy! I will say it once again, to insist on the arguments I’m seeing here is to reject, not just Mises and ABCT, but the whole of Wicksellian monetary theory. Perhaps some here are willing to go that far.

David asks, “What is the cyclical advantage of a secularly falling price level that you call for, if it is only accelerating inflation that is unsustainable?” The argument isn’t that accelerating inflation isn’t sustainable–it is that it must eventually lead to hyperinflation. What’s unsustainable is an excess credit-driven boom, with or without accelerating inflation.

As for the case for falling prices, the case for a deflationary trend (equal to the trend rate of productivity growth), as distinct from deflation reflecting cyclical productivity innovations, is not so much a matter of avoiding cycles as one of avoiding unnecessary noise in the price system from gratuitous monetary expansion that attempts, in effect, to substitute an upward trend in relatively sticky input prices for a downward trend in relatively flexible factor prices. (There is as well the fact that it gets things closer to Friedman’s optimal money stock.).

“A steady-state monetary expansion may give rise to a readjustment once it becomes fully anticipated, but it implies more or less the same equilibrium time path as that implied by a zero expansion steady state.”

Sure, but I’m not sure how this matters. On the blackboard at least, it doesn’t matter if we are in a steady state with 5% annual growth in base money or 3%. True enough. But what if the central bank *moves* from a 3% to 5% annual rate of increase in base money? Size matters. Presumably, in this hypothetical, there won’t be much of a cycle to notice. In theory, if the jump is unexpected, then the interest rate will be below its natural level for a bit and resources will tend to move toward interest-sensitive sectors. Given our hypothetical, we can figure that the public will catch on pretty soon and nominal rates will jump by about 200 basis points. At that point, resources tend to move back away from those same interest-sensitive sectors, causing losses in them. So you will have an Austrian cycle. But it’s not clear whether the size of the effect would be big enough to be noticed, say, in the financial press.

How any of that somehow adds up to a criticism of ABCT is not clear to me. The theory says that if you have monetary expansion that pushes the interest rate below its natural level, then you will have a self reversing boom, but it does not say that the effect must always be large no matter what. What kind of a theory would that be?

As for cultish followers . . . So what if some self-proclaimed “Austrians” are “cultish”? So don’t worry about them! You should take serious ideas seriously. But no one said you have to take on every self-proclaimed “Austrian” with an Internet connection. Gheesh.

Roger Koppl, no one’s idea, surely, of an “acolyte,” takes the words out of my mouth. Hawtrey, Keynes, Friedman, Wicksell, and…yes, Mises and Hayek: let us not make a desire to disassociate ourselves from acolytes a reason for rejecting ideas of some potential explanatory power, however small that power may be in any instance, too readily. As David quite rightly says, the relevance of the ABCT is ultimately an empirical question. To imagine that it can be answered a priori in the negative is to make be guilty of the same epistemological error as those extreme Austrians make the opposite claim.

MF, The real adjustment that you are describing is a response to an unanticipated inflation resulting from an unanticipated monetary expansion. The question that I am posing is suppose that the central bank allows the monetary expansion to continue as people come to anticipate it, but does not try to accelerate the expansion in order to create further unanticipated inflation. The expansion of output induced by the original unanticipated monetary expansion is indeed unsustainable once the expansion is no longer unanticipated, and there is a corresponding real adjustment associated with the adjustment of inflationary expectations to the increased rate of monetary expansion. But this is a relatively minor real adjustment and I don’t see any reason why this constant rate of monetary expansion, which just for the discussion purposes let us say corresponds to a steady rate of increase of nominal GDP of, say, 5% a year, could not be maintained indefinitely. Do you want to argue that it cannot be maintained indefinitely? Do you want to claim that ABCT holds that it cannot be maintained indefinitely? My understanding was that ABCT said that a steady rate of 5% increase in GDP is not indefinitely sustainable. But the quotation I cited from von Mises suggests that not only is it sustainable but that the it is even possible that the natural rate of interest will fall as a result of the monetary expansion further minimizing the extent of the real adjustment required to regain the equilibrium time path.

I actually have no idea what you are saying in your paragraph beginning with “after all,” so I am afraid that I cannot respond. I also can’t exactly figure out what you mean by “capital structure temporality,” but I do know what scarcity means, and I assure you that I was neither explicitly nor implicitly assuming that resources are not scarce.

George, Thanks for the elucidation of your views on the behavior of the price level.

You said:

“What’s unsustainable is an excess credit-driven boom, with or without accelerating inflation.”

Sorry, I don’t get that. You seem to be arguing in a circle. Isn’t an excess credit driven boom unsustainable because it leads to accelerating inflation which leads to hyperinflation?

Roger, My point is that what is usually considered to be the Austrian cycle is not that “, resources tend to move back away from those same interest-sensitive sectors,” when the public adjusts its inflation expectations, but that there is a monetary contraction. Under the gold standard the monetary contraction was caused by a loss of gold reserves and under a fiat money system by the attempt to reduce the rate of inflation back to some lower level. The Austrian component of the business cycle compared to the purely monetary component is thus, even in a garden variety business cycle, pretty modest, if not trivial. And in an episode like 1920-21, 1929-33 or 2007-09, it is almost vanishingly small. Whether that counts as a criticism of ABCT is irrelevant as far as I am concerned. I am just trying to get the analysis done right.

I take your point about not letting self-styled Austrian cultists have exclusive rights to Austrian theory. But one has to admit that there is plenty of material in Mises and Hayek (in his younger days) that suggests that any monetary expansion is poison.

George, Well said. I am encouraged that we seem to agree about more than we disagree about.

“This is really too much: even in hyperinflations someone demands the expansion of the money stock in the crude sense that someone accepts the money that’s placed into circulation, whether by lending or by means of helicopter drops.”

And what exactly precludes that expansion of money from funding the expansion of the quantity of goods? This is the conclusion that every ABCT follower seems to jump to. What I mean is that if you can offer the helicopter drop extreme example, I can equally offer my equally extreme investment example. I will take all that money dropped from a helicopter, use it to fund the creation of my energy to matter converter, and make 100,000 more helicopters. What happens to the price of helicopters?

“But such demand isn’t the same as demand for real balances”

I am not sure what you mean by demand for real balances here. Are you talking about a demand for the production of goods and the consumption of goods to always be in balance (neither deflation nor inflation). A nice trick, but I would think market frictions would prevent it.

“Its presence in no way precludes the public from being capable, all the while that it accepts new money, from fearing the consequences of too much of it being created!”

So the public should jump to the conclusion that excess credit causes inflation in and of itself and the public should be fearful of it because???

“What’s unsustainable is an excess credit-driven boom, with or without accelerating inflation.”

And the definition of excess would be – what exactly? If I am reading you correctly, the answer would be credit expansion that puts a strain on available real resources. But that is a function of how credit is used, not whether there is too much or too little of it.

MF above had this to say:

“The two main lessons that Glasner and other non-Austrians need to understand is 1. Resource scarcity, and 2. Capital structure temporality.”

And I understand resource scarcity very well. I just don’t buy into the whole notion that credit expansion must always and forever put a strain on those resources. I believe, in fact I know, that how money is used is just as important (if not more so) than how much of it there is.

We seem to have different views of “what is usually considered to be the Austrian cycle.” In what *I* think is “usually considered to be the Austrian cycle” self-reversing movements in the time structure of production are not absent, but central. Nor am I aware of anything in Mises or Hayek to suggest that “any” monetary expansion is “poison.” Indeed, Hayek clearly articulated a policy of constant “circulation” (=MV), which implied the need to pump the money supply back up during the Great Contraction. In practice, I’m afraid, Hayek made the wrong monetary call during the Great Depression. Yep, he sure erred on that one. Personally, I don’t get so hot and bothered over this error of judgment. Most economist did not have a good picture of the events of the Great Depression until Friedman & Schwartz published their history in 1963. Clark Warburton was way ahead of them, but they were the ones that got the bulk of the profession to see what had happened. Until then, everyone was pretty much groping in the dark, making it no surprise if an otherwise brilliant economist should make the wrong policy call in the midst of events. All of that puts us far from any supposed claim that “any” monetary expansion is “poison.” On these points, David, I think you’re just mistaken and demonstrably so.

Roger, What I meant, but did not articulate very well, is that adjustment in the time structure of production is more in the nature of a sectoral shift, and therefore less relevant to overall cyclical changes in output and employment, than a monetary contraction. It’s not the Austrian cycle is the stylized facts associated with business cycles. Without the monetary contraction there would be a smaller effect on output and employment than with the monetary contraction.

Concerning monetary expansion, there are countless statements by both Mises and Hayek about monetary expansion being the source of the disease, so that a cure is impossible if the cause of the disease is not eliminated. I am aware that Hayek formulated a constant MV policy. Larry White’s paper on the subject overrates the importance of the constant MV policy which was only suggested tentatively as a policy in Prices and Production. In the context of the Great Depression, implementing a constant MV policy was incompatible with maintaining the gold standard, because gold was appreciating and prices falling. Hayek never seriously considered abandoning the gold standard in order to stabilize MV. And certainly Mises would have been outraged at the suggestion. Actually, not everyone was as clueless as Hayek and Mises as Ron Batchelder and I have argued in our paper on Hawtrey and Cassel, who totally understood what was going in the Great Depression before, during, and after it happened, and whose explanation is superior to the Warburton/Friedman and Schwartz version in almost every respect. Hawtrey, although Hayek always wrote about him respectfully, was generally regarded by Austrians as a dangerous monetary manager.

JP, Yes it does, but more to do with Keynes’s point that the real rate of interest varies according to the state of employment, so the natural rate cannot be taken to have a fixed value that is independent of the state of the economy. The natural rate is probably negative now, but if the economy were operating somewhere close to capacity it would likely be at least 2 percent.

“I meant . . . adjustment in the time structure of production is more in the nature of a sectoral shift, and therefore less relevant to overall cyclical changes in output and employment, than a monetary contraction.” Ah! I probably should have realizes as much. Perhaps I still don’t quiet understand you, but it seems like you’re just defining away an “Austrian” aspect of the problem.

Are sectoral shifts an important part of the story or not? I think they are important if only because they are part of the mechanism linking monetary ups and downs to real ups and downs. So they matter in some sense even when they are not otherwise important. It seems that in the 1920s the NBER series showed pig iron moving up and down more dramatically than other series, and it seems this was thought to require explanation. It was Lakatosian “excess empirical content” on the side of the Austrian theory. And yet you seem, David, to do what I think others have done, namely, count that excess empirical content *against* the theory! Anyway, let’s now flash forward from the1920s back to the early 21st century. One of the salient features of the recent crisis has been, of course, the housing crisis. I think the Austrian theory helps to explain why the boom was concentrated in part in that sector. Of course there is still the whole story of the Fannie and Freddie, the rating agencies, and so on, but IMHO the “Austrian” story of sectoral shifts helps explain Why now? and Why so big? Andy Young of WVU has done a nice study that tends to show that the Austrian story fitst the recent crisis well. http://www.springerlink.com/content/68h2307p03352751/

As for whether “any monetary expansion is poison,” your clarifying remarks map out a more reasonable and acceptable view. It’s not that any event that may be classified as “monetary expansion” sends us all straight to hell. I don’t think Mises or Hayek ever said such a thing. I would even deny that monetary expansion is always the source of the disease for Mises and Hayek. First, I don’t think either one denied that a nontrivial, exogenous decline in base money would typically create an excess demand for money and corresponding excess supply of goods. I don’t think they denied the possibility of “non-Austrian” causes of “cyclical” unemployment. Second, there is point that Hayek at least came to see the value of re-inflation during a “secondary crisis.” I will let you and Larry White discuss whether his theory as of 1931 yields that insight. Certainly, he came around to that view later. Finally, the story was never really that monetary expansion is the problem. The story was always about the interest rate. If “the” market interest rate falls below its natural level, you will have a self-reversing boom. If-then. You can have the “then” part without the “if” part. And, as both George and I have noted on this thread, it’s an empirical question whether the size of the effect is big or small in any given historical case.

Some of your remarks might almost suggest that you interpret Mises and Hayek to say that a fixed x% annual rate of growth in money or base money will create a cycle. Presumably, you don’t mean to say that, but I think it may be worth pointing out on this board that any such statement would be mistaken. Any such view would be, indeed, a pretty fundamental error.

David asks, “Isn’t an excess credit driven boom unsustainable because it leads to accelerating inflation which leads to hyperinflation?”

That’s not correct. You can have an unsustainable boom with excess monetary expansion that doesn’t lead to accelerating inflation. A one-time increase in the money growth rate that raises the equilibrium rate of inflation, but without generating an accelerating rate, can have short-run Wicksell and related ABCT effects.

Accelerating inflation is an unintended consequence of a central bank’s attempts to combat the tendency of such a boom to end by increasing the rate of monetary expansion whenever interest rates start to creep up. Such attempts are ultimately futile. They cannot keep the boom going forever, but they can lead to hyperinflation. But of course central banks don’t always engage in such futile attempts to prevent booms that their policies help trigger from coming to an end. That ‘s why it is not at all inconsistent to claim that episode X involved an unsustainable ABCT-type boom even though it didn’t involve an accelerating rate of inflation.

Roger, I’m not defining it away, but I do very much question the relevance of the Austrian theory for deep recessions which I maintain are largely attributable to monetary shocks not to the real adjustments that are emphasized by Austrian theory.

I don’t count excess empirical content against Austrian theory, but I don’t think it counts more than minimally in its favor inasmuch as there are plenty of other explanations for the volatility of investment which accounts for particular empirical observation you are referencing. On the role of the housing bubble in the 2008 downturn, I am not sure how much that cuts in favor of Austrian theory inasmuch as there are multiple explanations for the bubble, and you don’t need the Austrian theory of capital to infer that reduced long-term interest rates will raise the value of long-lived assets. You get that result from every neoclassical model. So to say that the Austrian story fits the recent crisis well is not really setting the bar very high.

About the effects of monetary expansion, it seems to me that Hayek was pretty explicit in saying that constant MV was in principle the criterion for whether monetary policy is neutral. I agree with you that the generalized version of this criterion would be a constant predictable increase in MV. But Hayek never seemed to accept that generalization and explicitly challenged it in his 1968 paper “Three Elucidations of the Ricardo Effect.” I don’t deny that Hayek understood at some level that inflation to keep MV constant was the correct policy as early as 1931, but he was unable to draw the appropriate policy conclusion from that insight, the reason being, I conjecture, his attachment (at that point) to the gold standard.
I agree with you that the important issues are empirical (about the relative magnitude of theoretically possible effects). I wrote this post and the previous one, largely because it was my impression that ABCT holds that any monetary expansion must necessarily lead to a crisis. I am glad to hear that you and George both agree with me that that proposition is mistaken. What remains at issue is which Austrian theorists ever did believe it to be true and which current adherents of ABCT still believe it to be true. As I said, I am not convinced that Mises and Hayek can be absolved from that error. But I am willing to keep an open mind about that question.

George, No need to repeat what I just said to Roger. I think that the specific point that we are now arguing about is largely semantic. What you call an unsustainable boom is an allocation of resources induced by an unanticipated monetary expansion which will have to be reversed or altered once the monetary expansion is correctly anticipated. We agree on the analysis. What we disagree about — and it is likely a small disagreement – is whether the real adjustment qualifies as the upper-turning point of a business cycle. But there is also the further question prompted by the quotation I found in The Theory of Money and Credit at pp. 361-62 in which Mises conceded that a monetary expansion could actually cause a permanent reduction in the natural rate of interest and therefore would entail no subsequent real reallocation.

Increasing the supply of money does not increase the availability of inputs. It merely make them appear more abundant until the prices adapt to the change. Expansion of the money supply through credit makes it appear primarily to the people borrowing money that there are more inputs available, and they will invest them into endeavors that suddenly appear to be profitable, but without the change in the money supply they wouldn’t appear profitable. This creates the boom.

However, at those prices, the inputs must be depleted before the projects could be brought to fruition. So eventually either the inputs are depleted or (more likely) the price structure changes in a way that makes the original plans unprofitable. This is when the bust begins.

The bust then ends when the prices structure equilibrates again. Increasing the money supply during a bust however has the effect of preventing the equilibration and maintaining the unsustainable price structure.

It is factual / empirical patterns in the actual world which raise problem and which much be explained.

In the real world, there were construction projects all across America which were left uncompleted or which were bulldozed — in California, Nevada, Florida, and elsewhere.

That is a fact. You can watch the video or look at the pictures on the Internet — housed bulldozed, massive condo projects left uncompleted and rotting.

Economists need to explain that. To paraphrase Ronald Reagan, one definition of an economist is somebody who sees something happening in the real world, and wonders how he can can make it happen using his mathematical toys.

David writes,

“Why doesn’t the price mechanism allow resources to be allocated in a way that allows the half-finished, or three-quarters resources to be completed rather than be completely abandoned.”

Darn tootin’. And for a simple reason: you describe the dangers of excess monetary expansion, and conclude that what’s needed is an “inelastic” (that is, constant) money supply. That’s a non-sequitur: since the demand for money (or, more correctly, its velocity) also varies, a constant money stock doesn’t necessarily avoid short-run monetary shortages or surpluses. Monetary expansion is desirable when it merely makes up for a decline in money’s velocity.

The Rothbardian argument that a constant money stock is the best way to avoid cycles is, in short, analogous to the argument that the best way to regulate one’s weight is to refrain from eating altogether.

David, in the late 2000s I drove past 40 miles of mothballed lumber hauling rail cars — endless miles of rail cars which were in storage on old unused rail lines, one of _several_ such stockpiles of lumber hauling rail cars in the United States.

So answer your own question, “Why doesn’t the price mechanism allow resources to be allocated in a way that allows productive resources to be put to productive use rather than abandoned.”

Hayek has a powerful explanation which fits the _systematic_ pattern in front of our eyes — some goods become _noneconomic_ goods, when the structure of relative prices and the TIME structure of the production and consumption process shifts systematically.

Lumber hauling rail cars are very _specialized_ production goods.

There are _no_ specialize production goods most all of ‘mainstream’ economics — making it impossible for that attempt at ‘science’ to even engage the phenomena which creates problem raising patterns demanding our explanatory attention.

I already explained to you in the past where I think your error is. You conflate demand for a medium of exchange with lower transaction costs one one hand with demand for saving on the other, because empirical historical data shows them manifesting in one product, inside money (or in Mises’ terminology, money substitutes). But this is an empirical issue and not an economic rule. If the transaction costs of outside money are sufficiently low, these two demands won’t be satisfied by the same product anymore. There would be no inside money.

So even if you were correct that inelastic supply does not create an equilibrium, it still does not follow that free banking does. It would be merely by pure coincidence that the short term surplus or shortage of money would be at the level corresponding to the changes in the money supply produced through credit expansion/contraction.

The desire for inelastic money supply seems to stem from inelastic thinking as to what kinds of local growth are “permissible”: The recent example I’ve observed is an expanding refinery which needs more local housing for workers who will participate in the expansion. However, the locals are out in force to prevent an RV park from being built for those workers. I imagine that “closed mind” scenario gets repeated in plenty of places unfortunately. What’s more the city has long term issues with upgrading water infrastructure, which extra taxes from the RV park could help with.

My reading of Austrian business-cycle theory, in general, and, until last night as I was writing this post, of Mises, in particular, was that a monetary expansion at even a constant rate is unsustainable. If you say that that is not a proposition of ABCT, I am happy to hear that, but how would you square that with the Austrian theory of the Great Depression. Am I supposed to believe that not only were the 1920s a period of inflation, but a period of accelerating inflation? If the 1920s were not a period of accelerating inflation, please explain to me what was unsustainable about the so-called inflationary boom of the 1920s. I would also like to know, under this interpretation of ABCT, what distinguishes ABCT from Friedman’s natural rate of unemployment model? I agree that Mises and Hayek anticipated Friedman’s discussion by a good three or four decades, but what is the value added of the Austrian capital theory if you get the same basic result out of either approach. Or let me put it to you another way, as the author of the fine book Less than Zero. What is the cyclical advantage of a secularly falling price level that you call for, if it is only accelerating inflation that is unsustainable?

The 1920s was a period of accelerating aggregate money supply inflation. There was not an acceleration of consumer price inflation, since productivity was so high, and there was not an acceleration in the monetary base, since most of the monetary inflation took the form of credit expansion, so most economists who only look at price levels and monetary bases tend to dismiss the Austrian claim that the 1920s was inflationary.

The data for M2/M3 unfortunately is not readily available for the 1920s, but there are various sources that do have information on what happened to bank deposits, reserve requirements, checking accounts, and so on. This data shows a significant aggregate money supply growth.

After 1929, Austrians diverge as to the cause of the severity of the bust. Some believe the money supply fell too much, others believe it wouldn’t have fallen so much if there weren’t so many problems in the first place (1920s). In truth, I don’t think any side can definitely claim to be right, because nobody can know what the true free market supply of money would have been, since this is a counter-factual and is not observable. I think the issue can be resolved if we identify the anchoring bias for each side. Hard money Austrians say the market was re-asserting itself after a prior non-market inflation. Soft money Austrians say that the market would not have had such deflation, so there is no reason why the Fed should have let it happen.

Personally, I think the latter soft money view is wrong, because it takes for granted the assumption that the Fed should correct its past mistake by imposing a new mistake of the same type: Ignore the market and pretend that the 1920s never happened.

MF, The real adjustment that you are describing is a response to an unanticipated inflation resulting from an unanticipated monetary expansion.

Actually no. The real adjustment will take place with or without “unanticipated” inflation. The very fact that the central bank has to accelerate credit expansion to prevent these painful relative price adjustments from transpiring, even in a rigid monetary policy targeting regime that is expected, is sufficient evidence that a real adjustment “wants” to transpire.

No individual market actor can know what the relative price structure should be, or would have otherwise been in a free market, so it is not enough that market actors correctly anticipate various aggregate price level or spending level or money supply statistics. These aggregates are not providing the required information as to the time preferences that market actors have that investors need in order to enable their quest for profits to have a benevolent side-effect of ensuring that relative prices are in coordination with actual time preferences, rather than a malevolent side-effect of bubble manias.

The question that I am posing is suppose that the central bank allows the monetary expansion to continue as people come to anticipate it, but does not try to accelerate the expansion in order to create further unanticipated inflation.

You are posing a Friedmanite fixed rate of money supply growth rule? That will sacrifice being able to have a fixed NGDP growth, since cash preferences will fluctuate.

A fixed rate of growth of money supply does seem like a solution to eliminating the boom bust cycle. But upon closer analysis, it too is unsustainable in the long run. Why? Because with a constant and perpetual rate of increase in money out of thin air, a constant stream of various unproductive, wealth consuming activities will spring up on the back of such inflation. That is what a constantly growing money supply regardless of market actor preferences does. Imagine yourself to be given a constant source of cash no matter what you did. Would your activity tend to be wealth generating or wealth consuming? There is no market test of profit and loss against your constant cash influx, so your activity will tend to become wealth consuming, even if you think you are being productive and employing people to do X. Not all seemingly productive activity is wealth generating. You could be building things all day every day, and be consuming wealth on net regardless.

As the money supply growth rule remains in force, more and more unproductive activities will spring up over time and accumulate, and more and more wealth generators will be undermined. Once the unproductive activity composes 50% of the economy (note that this “unproductive activity” may appear as productive, due to there being “output” and “employment” taking place), after that 50% is reached civilization will begin to collapse. A slow, gradual, but relentless replacement of wealth generating activity with wealth consuming activity will take place, and while things may initially appear to be “stable” from a short term perspective (which right away will convince probably 99% of economists of its superiority and sustainability), there will be a continual degradation in the long run.

The expansion of output induced by the original unanticipated monetary expansion is indeed unsustainable once the expansion is no longer unanticipated, and there is a corresponding real adjustment associated with the adjustment of inflationary expectations to the increased rate of monetary expansion. But this is a relatively minor real adjustment and I don’t see any reason why this constant rate of monetary expansion, which just for the discussion purposes let us say corresponds to a steady rate of increase of nominal GDP of, say, 5% a year, could not be maintained indefinitely. Do you want to argue that it cannot be maintained indefinitely? Do you want to claim that ABCT holds that it cannot be maintained indefinitely? My understanding was that ABCT said that a steady rate of 5% increase in GDP is not indefinitely sustainable. But the quotation I cited from von Mises suggests that not only is it sustainable but that the it is even possible that the natural rate of interest will fall as a result of the monetary expansion further minimizing the extent of the real adjustment required to regain the equilibrium time path.

No inflation rule tinkering can ever crack the armor of ABCT. Why? Because ALL inflation hampers economic calculation, and economic calculation is the backbone of ABCT. There really is no substitute for a free market in money.

Whatever non-market inflation rule you consider, the very fact that your rule is not subjected to the market test of profit and loss, the fact that it is continually enforced against the counter-acting market forces, makes the rule an unsustainable one. The market will get sicker and sicker until what was originally overlooked due to overly dependent positivist-empiricism methodology, will finally become so obvious as to be unmissable, but of course by that time, it will be too late. ABCT requires one to have a very long term outlook, and to be able to think in ways that seem to contradict every day “official” data. You have to be willing to say we should stop spiking the punchbowl even though everyone is having a great time.

I actually have no idea what you are saying in your paragraph beginning with “after all,” so I am afraid that I cannot respond. I also can’t exactly figure out what you mean by “capital structure temporality,” but I do know what scarcity means, and I assure you that I was neither explicitly nor implicitly assuming that resources are not scarce.

My apologies for being unclear, I was just adding to Selgin’s point. In that paragraph you refer to, by “capital structure temporality” I mean the structure of production as it relates to intended time horizons of investments. It is one thing to say we have a capital stock X. It is another thing to say what the structure of that capital stock is that relates to how far into the future the individual investments are oriented. The more future oriented investments are, the more savings and capital are required to complete those projects.

If you view the capital stock in terms of temporal horizons of investments, then you can imagine that a healthy economy is one where each investment horizon to consumption, each stage, is in balance with every other stage. Balance is needed because of resource scarcity. Without scarcity, any stage could be infinitely expanded, and economic production will not be adversely affected.

As an example, consider a pencil as a consumer good. In order to produce pencils, various temporal stages of production are required. Mining and raw materials (graphite, wood, copper, etc), then durable goods manufacturing (machinery, wood cutters, metal templates, etc), then non-durable goods (materials, rubber, paint, packaging, etc), then assembly (pencil factory), then wholesale, and then retail. If there is not enough paint, say, and too much wood, say, then the production of pencils is not in balance. Losses will be incurred. There needs to be relatively more resources put into paint, and relatively fewer into wood cutting.

The capital structure temporality refers to how far into the future investments are directed. If the wood cutters are producing such a significant amount of wood that, in order to complete as many pencils as this wood implies, requires more paint and metal than is actually available, then the wood cutting industry will inevitably suffer losses. The capital structure is not in balance. It is too “future oriented.” More savings and capital are needed than are actually available.

In Austrian theory, interest rates (NOT interest rates on loans, but originary interest rates) serve to regulate the temporal structure of the economy, and to regulate accumulated wealth consumption. If inflation of the money supply is constant, then the short term effect of “temporarily” lower interest rates will always be present, because there would be no way for investors to discern what the real market rate of interest is by separating out from nominal rates an inflation component.

It is not the case that investors can look at consumer price inflation, estimate an index of 2% say, and then subtract that rate from the nominal rate on government bonds say, after which out pops the “real” market interest rate that investors can calculate with. This is a gross misjudgment of what real interest rates mean in Austrian theory. In that theory, real interest rates are in fact the difference in demands of future goods and present goods. It is manifested by relative profit rates. Inflation affects relative profit rates and so affects the structure of production in ways that cannot be corrected by investors through using existing data, because it is precisely the existing data that is affecting their actions.

It would be like maintaining a rate of alcohol consumption and then trying to discern how much of a single action is caused by alcohol and how much is caused by soberness. It’s impossible to do, because the only data we have is a drunken person’s single action. It would be wrong to claim that we can discern a person’s “sober” actions by observing how many burritos they eat, or whatever, and then subtracting those burritos and out pops what they would have done otherwise. It is a vain quest.

The only way we can know what that person will do sober on such and such a day, is if and only if he is sober to begin with.

“Why doesn’t the price mechanism allow resources to be allocated in a way that allows productive resources to be put to productive use rather than abandoned.”

Those lumber hauling rail cars that you speak of once had a value that was more than the sum of the costs of constructing them aka a utilitarian value. And so the railroad company that purchased those rail cars paid a premium above the cost inputs to construct them to realize that utilitarian value. So what happens when the utilitarian value is diminished – railroads displaced by superhighways and trains displaced by trucks? The owner can either chose to hang on and hope that utilitarian value returns, or can try to recoup the liquidation / scrap value of the cars.

And this is where things get tricky – in liquidating the cars the owner sets the market value for those cars. Recognize that the value of a company is inherently the liquidation value of its assets plus the utilitarian value of what it produces, a company can try to liquidate its assets or GUESS what those assets might be worth in a liquidation process. This becomes important to owners of the firms liabilities (debt and equity holders).

So what can be done? The U. S. tax code handles this in part with depreciation of assets. Meaning companies that buy long lived assets can take a capital loss (wear and tear) on those assets and deduct it from their taxable income. I am not real familiar with the depreciation schedule, you would need an expert in corporate taxes.

But the tax code (as currently written) is designed for normal wear and tear of those assets not for total loss of utilitarian value. For that, either the federal government must be willing to step in as a buyer (see S&L bailout) OR the federal government must be able to adjust the after tax cost of money down to the point where liquidation of those assets while maybe not profitable, does not sink the company.

You also wrote:

“In the real world, there were construction projects all across America which were left uncompleted or which were bulldozed — in California, Nevada, Florida, and elsewhere. That is a fact. You can watch the video or look at the pictures on the Internet — housed bulldozed, massive condo projects left uncompleted and rotting. Economists need to explain that. To paraphrase Ronald Reagan, one definition of an economist is somebody who sees something happening in the real world, and wonders how he can can make it happen using his mathematical toys.”

Ultimately what distinguishes a credit induced bubble from just normal economic activity is when the market value of an asset exceeds the sum of its liquidation + utilitarian value. What makes that tricky is that people buy things for their ephemeral or luxury value as well – I buy it because it makes me feel better about myself. And so with housing one man’s utility can be another man’s luxury. When luxury buyers (I buy it because I can) push up prices beyond the reach of utilitarian buyers (I buy it because I have a use for it), markets will crash.

If ABCT were phrased that way, “Markets crash when applied credit pushes asset values beyond the sum of their utilitarian and liquidation values”, I think you would see a lot of heads nodding. Market booms and busts are really not about too much credit or too little credit. They are about the misapplication of credit. And really that misapplication is a judgement call.

I feel like you’re shifting the goal posts, David. Now the issue is “deep recessions.” I’m not really sure what that means, but it sounds almost like you think that Austrian cycle theory should have somehow predicted in 1928 the length and depth of the Great Depression. Seriously, David, I don’t know what you want the theory to do that it isn’t doing.

You say, “you don’t need the Austrian theory of capital to infer that reduced long-term interest rates will raise the value of long-lived assets. You get that result from every neoclassical model.” I don’t understand this remark either. You seem to be saying that the “Austrian” mechanism for sectoral shifts is sensible and an implication of basic economic reasoning. Yes on both counts. You also seem to say that this fact somehow counts against it. Forgive me, David, but that seems perverse.

Then you say, “So to say that the Austrian story fits the recent crisis well is not really setting the bar very high.” Really? The theory is sensible, relies on basic economic reasoning, contains excess empirical content, and fits the facts. These points count in favor of the theory! You seem to count it against the theory that some “cultish” figures (on the Internet?) have said unreasonable things and claimed it was ABCT. Isn’t that like pooh-poohing modern physics because some people think it shows us how to make a perpetual motion machine?

“This is a gross misjudgment of what real interest rates mean in Austrian theory. In that theory, real interest rates are in fact the difference in demands of future goods and present goods. It is manifested by relative profit rates.”

But profitability is not just a function of the utilitarian value added in the production process. It is also a function of ephemeral value above and beyond the sum of the cost inputs and utilitarian value. You use pencils in your example. I will use cars in my example.

Cars have a set of cost inputs (labor, material, etc), a utilitarian value (a means of transportation), and an ephemeral value (brand name recognition, luxury, etc.).

And so do real interest rates in Austrian theory include the difference in relative profit rates when those difference in profit rates are not the result of differences in utilitarian value but instead differences in ephemeral value – I buy Chevy not because it is better or worse than Ford, I buy Chevy because my parents and grandparents have always bought Chevy’s or my favorite NASCAR racer drives a Chevy and I am willing to pay a premium for that choice.

As longest the expansion of money supply is coupled to Gold. I would have nothing against it. In a world of fiat money and debt driven countries. I can only see devastating consequentions like Greece and Spain.

Greg, I never said that it was impossible for real resources to become idle because the demand for what they produce drops precipitously or because the prices of cooperating inputs becomes prohibitive. This sort of thing happens from time to time. The question is whether this cyclical phenomenon is the cause of a downturn or the result of a downturn. Your citation of empirical facts that you have observed with your own eyes is no more persuasive than telling me that you have observed the sun rising and setting or that the ground beneath your feet is obviously flat.

Peter, Mises did not advocate the abolition of banks as credit creating institutions. He believed that central bank and other policies enabled banks to extend credit without bearing the full costs of doing so. So an inelastic money supply was not Mises’s solution; it was Rothbard’s. Not only do I agree with George’s previous response to you, but I suspect that Mises would have also, and there is no doubt that Hayek would have. The amount of money created by a free banking system tends to equal the amount of money that the public wishes to hold. Under a free banking system the amount of cash created by the banks will find its way back to the banks rather than into the spending stream because banks that create more cash than the public wants to hold will suffer a drain on their assets which they can make up only by paying more interest on deposits or by borrowing capital or selling stock. None of those is without cost, so there must be an equilibrium in which each bank is creating an amount of cash that is just equal to the amount of its cash that public wishes to hold.

Becky, The point is to make sure that the expanding refinery takes into account fully all the costs it imposes on the rest of the community by engaging in the expansion. Only if it does can we be sure that the expansion is worthwhile. The argument for free banking only works is banks are forced to take into account all the costs associated with their expansion. The argument against free banking is that banks habitually underestimate their costs. The argument against the argument is that the reason they do habitually do so is because of interventions by the government that hide or collectivize those costs. It’s complicated.

This is off topic but I have a question on how Austrians see uncertainty affecting interest rates.

ABCT rests on the assumption that without the CB artificially lowering interest rates they would be at the natural level that exactly matches time preference.

However uncertainty about the future will affect both lending and borrowing decisions. Banks may not want to lend if uncertainty is high which may cause IRs to rise, while businesses may not wish to lend which would have the opposite affect. This would seem to render IRs indeterminate.

Unless Austrians ignore uncertainty or assume it is constant how do they factor this into their models ?

David, it’s hard to interpret your reply as anything but a non-responsive dodge.

I pointed to _systematic_ phenomena of a very _particular_ sort, phenomena which give rise to a very specific problem raising pattern in our experience.

Your non-reply ignores the systematic & particular pattern I point out, and you then give reference to phenomena which do _not_ give rise to questions, unless some wider context is offered which problematizes the patterns you reference. But you then fail to do that.

Again, this is completely non-responsive, and does not in any measure engage the issue at hand.

What could you be thinking that leads you to image that this is anything but non-response.

I gave you a particular exemplar of a class of problem raising phenomena.

You simply dodged the questions by pretending otherwise.

If you aren’t serious about engaging the science you don’t like, just say so.

David,

“Greg, I never said that it was impossible for real resources to become idle because the demand for what they produce drops precipitously or because the prices of cooperating inputs becomes prohibitive. This sort of thing happens from time to time. The question is whether this cyclical phenomenon is the cause of a downturn or the result of a downturn. Your citation of empirical facts that you have observed with your own eyes is no more persuasive than telling me that you have observed the sun rising and setting or that the ground beneath your feet is obviously flat.”

“The 1920s was a period of accelerating aggregate money supply inflation. There was not an acceleration of consumer price inflation, since productivity was so high, and there was not an acceleration in the monetary base, since most of the monetary inflation took the form of credit expansion, so most economists who only look at price levels and monetary bases tend to dismiss the Austrian claim that the 1920s was inflationary.”

I don’t know on what you base your assertion that the 1920s was a period of accelerating inflation. That seems to be an article of faith among at least some Austrians, but there is no evidence of accelerating inflation. You dismiss actually looking at measured inflation rates, which I agree are imperfect measures of inflation under any circumstances, but even an imperfect measure ought to be able to show signs of an acceleration of inflation that according to you was the proximate cause of the worst economic catastrophe since the Black Death. I think that definitely counts as a point against your position. (By the way, I am not impressed by vague references to increases in bank deposits don’t impress me, because they tell us nothing about what was happening to the public’s demand to hold money, even apart from the possibility that you are relying on Rothbard’s notorious inclusion of life insurance policies in his calculation of the money supply during the 1920s.) But since you insist that measured inflation is essentially uncorrelated with the inflation that you think is relevant, let’s look at nominal GDP during the 1920s. According to you shouldn’t nominal GDP have been accelerating? Here’s nominal GDP during the 1920s.

From 1923 to 1929, the average annual rate of growth in NGDP was 3.9%, so in 1929 nominal GDP was increasing at a faster rate than the average over the entire period, but in 1928 NGDP was increasing more slowly than the average, so you are talking about accelerating inflation for a period of not much more than a year. Do you expect me to believe that accelerating inflation for a single year caused the Great Depression? Sorry, but I am not falling for that one.

You said:

“The real adjustment will take place with or without “unanticipated” inflation. The very fact that the central bank has to accelerate credit expansion to prevent these painful relative price adjustments from transpiring, even in a rigid monetary policy targeting regime that is expected, is sufficient evidence that a real adjustment “wants” to transpire.”

There seems to be some confusion here. In a “rigid monetary policy targeting regime that is expected” the central bank cannot accelerate credit expansion. So the real adjustment would have to take place in the context of an ongoing monetary expansion. I claim that the real adjustment that would take place in that context would be minimal (as in what used to be called a “growth recession”) compared to the deep absolute downturns that business-cycle theories seek to account for.

You also misunderstood my assumption of a central bank that “allows the monetary expansion to continue as people come to anticipate it” as referring to a “Friedmanite fixed rate of money supply growth rule.” I was actually thinking of constant NGDP growth precisely because the Friedman rule ignores changes in the rate of growth in the demand for money.

As for your arguments against either a Friedman rule or a fixed NGDP rule, the previous comments from ABCT proponents or sympathizers like Roger Koppl and George Selgin on this thread suggest to me that they, at any rate, would disagree with your analysis and your conclusions, so I will just leave it at that. If I am misunderstanding their position, of course, I hope they will weigh in and enlighten me.

Roger, Sorry about that, but this is an off the cuff conversation and an exchange of thoughts, so I am just responding on the spur of the moment. If you feel that I am being inconsistent, that’s certainly possible, but I am not trying to mislead you. About what I want from Austrian theory to do that it isn’t doing, I am asking retrospectively can the mechanism that the Austrian theory articulates account for the Great Depression. I am not asking for a prediction in 1928 of the Great Depression, although I will point out that Hawtrey and Cassel as early as 1919 or 1920 were warning of the huge deflationary risk of returning to the gold standard without also taking measures to limit the increase in the monetary demand that would likely be associated with a restoration of the prewar gold standard. I would also note that at least some adherents of ABCT, apparently on not such solid documentary evidence, credit Mises and Hayek with having predicted the 1929 downturn. At any rate, it does not seem to me that even with the benefit of hindsight that ABCT can tell us very much about the Great Depression. The mechanism that generated the Great Depression was almost totally monetary, and even if there was some real adjustment associated with the 1929 downturn, a proposition which I regard as highly dubious, it pales in comparison to the purely monetary element. Nor is there any reason to assume that the real adjustment was in any way integral to the monetary disturbance which was almost entirely a product of the behavior of central banks, notably the Bank of France and the Fed, in the context a widespread restoration of gold convertibility.

My point about the effect of interest rate on capital assets is simply that all you need to derive that proposition is to know the present value formula for stream of future cash flows. If that’s all we’re talking about what is the contribution of Austrian. What was the use of everything Hayek wrote about business cycles if it all boils down to a present value formula? Do you see what’s bothering me?

I think that my criticism is similar to what someone (I forget who) said about Keynes, which was that he said many things that were original and many things that were true, but that what he said that was original was not true and what he said that was true was not original. What I am suggesting may be true of ABCT is that whatever is true can be derived from other sources and what can’t be derived from other sources is not true. But I am not stating that categorically, I am just throwing that out as a hypothesis for discussion purposes. The reason that I am writing about ABCT is that I have been interested in it for over 30 years and am still trying to figure out its complexities. But another reason is that it seems to a lot of people to provide a rationale for not following the policies of monetary expansion that I think should be taken now, just as in the 1930s ABCT provided the rationale for opposing the monetary expansion that was necessary to overcome the Great Depression. In an ideal world, we would understand exactly what the valid insights of ABCT are and what the policy implications of those insights are and the circumstances under which those implications obtain. In our imperfect world, I think the most important lesson to learn is that ABCT provides very little useful information about countercyclical policy and that we should not pay much if any attention to ABCT arguments against monetary expansion when the economy is at or close to the bottom of a downturn.

Tas, Greece and Spain got into their current mess while monetary policy has been under the effective control of Mrs. Merkel, so I don’t think your objection to monetary expansion follows from the examples you are citing.

I don’t know on what you base your assertion that the 1920s was a period of accelerating inflation.

Aggregate money supply, but I thought I mentioned that.

That seems to be an article of faith among at least some Austrians, but there is no evidence of accelerating inflation. You dismiss actually looking at measured inflation rates, which I agree are imperfect measures of inflation under any circumstances, but even an imperfect measure ought to be able to show signs of an acceleration of inflation that according to you was the proximate cause of the worst economic catastrophe since the Black Death. I think that definitely counts as a point against your position. (By the way, I am not impressed by vague references to increases in bank deposits don’t impress me, because they tell us nothing about what was happening to the public’s demand to hold money, even apart from the possibility that you are relying on Rothbard’s notorious inclusion of life insurance policies in his calculation of the money supply during the 1920s.)

Huh? Bank deposits ARE actions of holding money. The demand for money is the totality of all cash deposits!

But since you insist that measured inflation is essentially uncorrelated with the inflation that you think is relevant, let’s look at nominal GDP during the 1920s. According to you shouldn’t nominal GDP have been accelerating?

No, nominal NGDP is irrelevant also.

Do you expect me to believe that accelerating inflation for a single year caused the Great Depression? Sorry, but I am not falling for that one.

Noticed how you just redefined inflation as NGDP. I only mentioned aggregate money supply. That is the main driver.

According to most credible sources, the aggregate money supply rose over 63% in the 9 years from 1921-1929, or roughly 7.7% per year on average (starting modestly and then quickening up as the decade progressed, reaching a peak just prior to the stock market collapse).

If you are going to correctly critique the Austrian view, you have to at least know the Austrian argument. You are talking about price inflation and NGDP and all these other statistics that many Austrians specifically warn AGAINST looking at when seeking to connect ABCT to empirical history.

You said:

“The real adjustment will take place with or without “unanticipated” inflation. The very fact that the central bank has to accelerate credit expansion to prevent these painful relative price adjustments from transpiring, even in a rigid monetary policy targeting regime that is expected, is sufficient evidence that a real adjustment “wants” to transpire.”

There seems to be some confusion here. In a “rigid monetary policy targeting regime that is expected” the central bank cannot accelerate credit expansion.

Unless the central bank specifically targets credit and speeds up and slows down its rate of monetary inflation in order to keep credit growth constant, then no rigid monetary policy regime can guarantee no accelerating credit growth. It doesn’t happen with price level targeting, or aggregate spending targeting.

So the real adjustment would have to take place in the context of an ongoing monetary expansion. I claim that the real adjustment that would take place in that context would be minimal (as in what used to be called a “growth recession”) compared to the deep absolute downturns that business-cycle theories seek to account for.

Your claim is unsupported by anything other than the premises already assumed in your fiat inflation model.

You also misunderstood my assumption of a central bank that “allows the monetary expansion to continue as people come to anticipate it” as referring to a “Friedmanite fixed rate of money supply growth rule.” I was actually thinking of constant NGDP growth precisely because the Friedman rule ignores changes in the rate of growth in the demand for money.

Constant NGDP growth cannot guarantee non-accelerating money supply inflation, which will have the inevitable outcome of either the central bank losing control of NGDP when the money supply gets so high that the central bank’s balance sheet is not large enough to soak up liquidity, or, if the central bank ceases the acceleration in money supply growth, then it will precipitate a recession, regardless of NGDP.

<blockquoteAs for your arguments against either a Friedman rule or a fixed NGDP rule, the previous comments from ABCT proponents or sympathizers like Roger Koppl and George Selgin on this thread suggest to me that they, at any rate, would disagree with your analysis and your conclusions, so I will just leave it at that. If I am misunderstanding their position, of course, I hope they will weigh in and enlighten me.

My suspicion is that you only feel apologetic towards folks like Koppl and Selgin because they would provide you with support against my view. That is why you “left it at that.” It’s because if the unstated belief were made explicit, it would be clearly seen as a rather weak justification (ad populum, etc).

————————-

Your original assertion that Mises doesn’t have a theory on why booms are unsustainable in a fiat standard was corrected by Robert Murphy a while back, after he showed you passages from Mises’ work you yourself cited.

Your response was an evasive and hand-waving exercise. You ignored the passages Murphy cited, and instead you cited other passages from Mises and then claimed they are not inconsistent with your original claim. That is a serious intellectual faux pas. It would be like asserting Friedman never advocated for a fixed money supply growth rule, by ignoring the times he did advocate for it, and instead focusing on some of his other writings that don’t explicitly contradict your assertion.

Then you give the absurd reposte that Mises…in 1912 mind you(!)…only considered a “hypothetical” world of fiat money inflation to show unsustainability of booms, as if Mises was obligated to collect empirical data in a fiat standard, so that he can show you an “empirical test” for his theory about fiat money. Yet in 1912 there was a (imperfect) gold standard. Do you see the problem?

Then you reluctantly grant that Mises did have a theory about hyperinflation in a fiat money standard, and you seem to agree with it, but then you say that this was already known all along, and ABCT is superfluous…

How do you expect to have an honest, open and fruitful discussion when you engage in this type of behavior? I thought this was going to be a serious critique derived from an informed perspective. This is pedestrian…

But profitability is not just a function of the utilitarian value added in the production process. It is also a function of ephemeral value above and beyond the sum of the cost inputs and utilitarian value. You use pencils in your example. I will use cars in my example.

Cars have a set of cost inputs (labor, material, etc), a utilitarian value (a means of transportation), and an ephemeral value (brand name recognition, luxury, etc.).

And so do real interest rates in Austrian theory include the difference in relative profit rates when those difference in profit rates are not the result of differences in utilitarian value but instead differences in ephemeral value – I buy Chevy not because it is better or worse than Ford, I buy Chevy because my parents and grandparents have always bought Chevy’s or my favorite NASCAR racer drives a Chevy and I am willing to pay a premium for that choice.

There is only one value schema in Austrian theory. They don’t divorce value into “production for profit” and “production for use.” Austrians hold all profit as “production for use.” The name brand of the car is in the same category of value as the use for means of transportation. Humans don’t just want to get from A to B, they want to achieve ends that are in part comprised of getting from A to B. Comfort, quality, all the things you call “ephemeral value”, as if they are not really values at all, are as fully valuable and useful as getting from A to B in Austrian theory.

The coordinating phenomena that derives from the profit and loss system is a coordinating of production for use, and that use encompasses everything from the motor movement of cars to the appearance of cars. Our eyes are important to us, which is why we pay to watch 3D movies in color in theaters, even though we could watch the same movie title on a black and white television (not to say that one cannot ever value a good black and white film on TV over a 3D color movie in the theater, it depends on subjective valuations, and in some instances, black and white are considered superior).

Profit and loss are in Austrian theory a mechanism of signals. The appearance of cars require production no less than the propulsion aspect of cars.

“There is only one value schema in Austrian theory. They don’t divorce value into “production for profit” and “production for use.” Austrians hold all profit as “production for use.” The name brand of the car is in the same category of value as the use for means of transportation.”

Then why exactly is credit expansion unsustainable? While it is true that we live in a limited resource world and so unlimited credit expansion can put strains on real resources. But ephemeral value does not have an “upper limit”. If someone wants to pay a couple hundred million dollars for a rare sports car, why does ABCT theory conclude that credit expansion used to facilitate that purchase is unsustainable?

I am not 100% sure myself that Mises advocated inelastic supply, I admit as much, and Rothbard was much more clear on that. However Mises did realise that increasing the money supply in any way creates a disequilibrium, with credit expansion causing a particular type of disequilibrium (the business cycle).

Now, it is true that the amount of money the public want to hold equals to the money supply. But this is a tautology, it’s not an equilibrating mechanism between credit and money supply. It’s a simply a restatement of accounts having to balance.

The most important thing to realise is that factors other than desire to save influence the choice between using credit or specie as a medium of exchange. Merely because people choose to deposit money in the bank to obtain interest, it does not automatically follow that they will use the credit instrument as a medium of exchange, and vice versa, merely because people want to use the credit instrument as a medium of exchange, it does not follow that they want to obtain interest. Even if you (and Selgin) don’t agree with me that this decision is based entirely on transaction costs (and therefore, in the extreme, if the transaction costs of monetary base were sufficiently low, only specie would be used as a medium of exchange), as long as you admit this influence is non-zero, the whole argument that credit and money supply equilibrate falls apart. A system with gold as a monetary base would exhibit a different money supply dynamic than a system with silver, because gold has different empirical features than silver. Since gold has a higher value per weight, I’d expect a higher proportion of the money supply to be specie under a gold standard than under a silver standard. But they can’t be both equilibrating at the same time, since they produce different results.

“I am asking retrospectively can the mechanism that the Austrian theory articulates account for the Great Depression.”

No! The Austrian theory of the *trade cycle* does not. But why should it? I think Bob Higgs’ notion of “regime uncertainty” helps explain the length and duration of crisis. My theory of “Big Players” analytically similar to Bob’s idea, BTW. Bob and I both consider ourselves to be “Austrians.” So “Austrian theory” in general may help explain the Great Depression. But ABCT can only explain the “upper turning point,” not he length and depth of the depression. How that’s a criticism of ABCT is a mystery to me. And, of course, I think most “Austrians” recognize the importance of the “Great Contraction” as explained by Friedman and Schwartz, which I mentioned above. If you feed the data of the Great Contraction into Austrian theory, the theory outputs a general collapse. So do other theories, which I fear you will take as somehow a criticism of the Austrian theory. If you think recovery was “slow,” then you need an explanation that goes beyond both trade cycle theory and standard monetary theory.

You say, “The mechanism that generated the Great Depression was almost totally monetary.” Maybe I should point out that ABCT is a monetary theory of the trade cycle. As Machlup put it: Monetary factors cause the cycle, but real factors constitute the cycle.

You say, “If that’s all we’re talking about what is the contribution of Austrian. What was the use of everything Hayek wrote about business cycles if it all boils down to a present value formula? Do you see what’s bothering me?” First of all, the NPV formula is relatively recent. Wikipedia says it goes back to Fisher 1907, which fits with my recollection of the history. So all the Austrian stuff on the time structure of production preceded the NPV formula. Maybe we could criticize Hayek for not importing the notion from Fisher, but I tend to think such a criticism might be anachronistic. Anyway, it is ambiguous to say “it all boils down to a present value formula.” ABCT has a causal story about sectoral shifts. NPV, with which we are *now* all familiar, helps tell the causal story. But NPV is not equal to that story. Honestly, no, I don’t really get what bothers you. If the points about the Austrian sectoral shifts turns out to be simpler than we had quite realized before, why is that a bad thing?

Finally, you say, “What I am suggesting may be true of ABCT is that whatever is true can be derived from other sources and what can’t be derived from other sources is not true.” (Minor point: the swipe at Keynes to which you allude came from Frank Knight.) Maybe this is the key to the whole thing. It seems like any “Austrian” point that can be made sensible and simple is then somehow demoted and no longer “Austrian” at all. It seems, then, as if you require that any “Austrian” point be, somehow, apart from ordinary economic reasoning or even ordinary scientific reasoning. But what, then is left? Almost any reasoning that is apart form ordinary scientific reasoning would be subject to the just criticism that it is not, you know, scientific! (I stick in the hedge “almost” for a reason. Think, e.g., of paraconsistent logics. But realistically, such things don’t seem to matter in this discussion.) Thus, is seems like you are somehow demanding that “Austrian” arguments be extra-scientific or something like that, which would then rule them out of court for most reasonable researchers. In other words, Austrian economics is wrong by definition and if your so-called “Austrian” theory of something is reasonable or even true, then that’s just proof that it is not really “Austrian” after all. Please forgive me if I sound a bit caustic, David, but I have been driven to this interpretation by our discussion on this thread.

Rob, I think you raise important questions for Austrians, and I won’t presume to try to answer on their behalf. My own view is that the natural interest rate is inherently unobservable and there is no guarantee that pure market forces would always cause the natural rate to correspond to the market rate, in the absence of any central bank intervention. Indeed in Monetary Theory and the Trade Cycle, Hayek, followed Wicksell in assuming that an endogenous business cycle was the result of changes in the natural rate that were only followed with a lag by market rates. The lag was the result not of intervention but of imperfect information that kept market rates from immediately adjusting to whatever underlying changes caused the natural rate to go up or down.

Greg, You cited the existence of a lot of half-finished homes as support for the notion that the cause of the 2008 downturn was a real maladjustment of the type identified by Austrian theory. My response to you was simply that there is a possibility that the disturbance that you are focusing on would not have created an economy wide downturn but would have had only a limited macroeconomic effect had there not been a monetary policy failure. If you think that that is an inadequate response to your point, you why don’t you just say so without the diatribe?

MF, OK you said aggregate money supply, but you also said that the data for M2 and M3 are not available, so I still don’t know what you are relying on when you represent to me that “according to most credible sources, the aggregate money supply rose over 63% in the 9 years from 1921-1929, or roughly 7.7% per year on average (starting modestly and then quickening up as the decade progressed, reaching a peak just prior to the stock market collapse).” Would you care to identify your unnamed credible sources and provide the numerical estimates that show that the rate of increase in the money supply was accelerating until just prior to the stock market collapse?

In Table 4.8 of their Monetary Trends in the United States and the United Kingdom, Friedman and Schwartz report annual figures for the money stock (defined as currency held by the public plus adjusted deposits at all commercial banks).
Year —–Money Stock —- % change
———- (billions of $)
1920——-34.80
1921——-32.85——— -5.8%
1922——-33.72——— 2.6%
1923——-36.60——— 8.2%
1924——-38.58——— 5.3%
1925——-42.05——— 8.6%
1926——-43.68——— 3.8%
1927——-44.73——— 2.4%
1928——-46.42——— 3.7%
1929——-46.60——— 0.4%

So, according to Friedman and Schwartz, in contrast to your unidentified “most credible sources,” the money supply increased by 34% in 8 years or just over 3% a year. (By the way, a 63% increase over 8 years – there are 8, not 9, years of growth between 1921 and 1929 — corresponds to a compound growth rate of just over 6% a year, not 7.7%; growth rates get compounded.)

The only reason I brought in NGDP was that you said that “the data for M2/M3 unfortunately is not readily available for the 1920s,” so I used NGDP as an alternative measure. Neither the money supply data of Friedman and Schwartz nor the NGDP data show any evidence of accelerating inflation. All you have done is cite unnamed “most credible sources” for a 63% increase over 8 years, representing that the rate was accelerating over the decade but providing no numerical measurement of the acceleration.

You said:

“Your original assertion that Mises doesn’t have a theory (on) [of] why booms are unsustainable in a fiat standard was corrected by Robert Murphy a while back, after he showed you passages from Mises’ work you yourself cited.

“Your response was an evasive and hand-waving exercise. You ignored the passages Murphy cited, and instead you cited other passages from Mises and then claimed they are not inconsistent with your original claim. That is a serious intellectual faux pas. It would be like asserting Friedman never advocated for a fixed money supply growth rule, by ignoring the times he did advocate for it, and instead focusing on some of his other writings that don’t explicitly contradict your assertion.”

Actually, your representation of what I said is not entirely accurate. In my original post, I acknowledged that Mises and Hayek provided an argument for why even a central bank not constrained by the gold standard or some other barrier to its monetary expansion would have to stop expanding. I made two points about that argument. First, we would have to go to Mises’s first edition in German to see whether he made the hyperinflation point in 1912. Second, unlike the gold standard which requires the central bank to set an interest rate sufficient to keep whatever level of reserves it feels it requires or wants to have available while maintaining convertibility, which means that the central bank will place a higher priority on keeping its gold reserve at a particular level than on maintainng full employment, the hyperinflation constraint requires no more than that the central bank refrain from hyperinflating. It is not clear that the two regimes produce the same cyclical pattern.

You said:

“Then you give the absurd reposte that Mises…in 1912 mind you(!)…only considered a “hypothetical” world of fiat money inflation to show unsustainability of booms, as if Mises was obligated to collect empirical data in a fiat standard, so that he can show you an “empirical test” for his theory about fiat money. Yet in 1912 there was a (imperfect) gold standard. Do you see the problem?”

You misunderstand what I was saying. I was not criticizing Mises for not discussing fiat money in 1912. I was just observing (or engaging a bit too casually in informed speculation) that the original discussion of the Austrian theory was, for quite legitimate reasons, focused on the contemporary institutional framework, namely the gold standard. So far no one has actually looked up the original 1912 German edition to tell us what Mises said about what the business cycle would be like under a fiat standard. I was simply making what I thought was a pretty innocuous claim about the original version of the Austrian theory. I should have made that remark in a more qualified manner, inasmuch as I was working from my recollection of the 1934 edition which I read many years ago and occasionally go back to as a reference.

“Then you reluctantly grant that Mises did have a theory about hyperinflation in a fiat money standard, and you seem to agree with it, but then you say that this was already known all along, and ABCT is superfluous…”

You misunderstand me again. I said that Mises had a theory of inflation that correctly saw that the tendency of inflation to increase output and employment would tend to dissipate as the inflation became anticipated so that the only way to maintain the increased level of output and employment was by constantly increasing inflation which would lead to an economic breakdown. I have no problem with that analysis, but that analysis does not demonstrate that a constant rate of inflation is not sustainable, and it doesn’t demonstrate why a central bank that did inflate for a time could not simply stabilize that rate of inflation without going all the way back to a constant money supply, which, I gather, is what you would be in favor of.

Peter, People have a choice between holding currency, coins, bank notes, and deposits. Their choices among them depend on the transactions costs of conducting exchanges, the cost of holding the different alternatives (is it equally costly to hold $10,000 cash or coin in a safe in your home or in a bank deposit) and the expected yield from holding the alternatives (some pay interest, some do not). The entire 19th century saw a shift from all other forms of holding cash and performing transactions to deposits. I think that was pretty powerful evidence of the relative costs and advantages.

You said:

“Now, it is true that the amount of money the public want to hold equals to the money supply. But this is a tautology, it’s not an equilibrating mechanism between credit and money supply. It’s a simply a restatement of accounts having to balance.”

I disagree. It is absolutely not a tautology and the equilibrating mechanism is the interest paid on deposits.

Roger, If you are suggesting that there is a convergence between Austrian theory and neoclassical economics, I am certainly in favor of such a convergence. I am willing to accept the possibility that there have been recessions that were caused by an upper turning point of the sort described by Austrian theory. Are you prepared to accept that not every recession was caused by an “Austrian” upper turning point?

About the Great Depression, when I say that Great Depression was almost totally monetary, I mean that it was the result of an exogenous deflationary monetary policy shock (as, by the way, was the 1920-21 downturn). I am well aware that ABCT is a monetary theory, but not every monetary theory (or impulse) operates via the Austrian mechanism.

I’m a bit confused by your chronology inasmuch as Fisher’s 1907 publication preceded and was certainly well known to both Mises and Hayek. As for the rest, I don’t think that we are really disagreeing about all that much, so I don’t see the need for us to further rehash semantic nuances.

you’re contradicting yourself. First you admit that transaction costs influence the choice of depositing money into the bank, then you say that they don’t.

You provide 19th century as an example of a shift. But the transaction costs difference persists even now. The monetary base consists of cash (which is clumsy to use), and the reserves commercial banks have with the central banks (which normal people are not permitted to obtain). So logically, for the normal guy, credit instruments have a transaction cost advantage over monetary base.

At best, what you proved is that if the transaction costs of specie are sufficiently high, the money supply would only consists of credit instruments.

The problem, you see, is mixing two things: obtaining interest from the bank, and using the instrument issued by the bank as a medium of exchange. There is no economic rule connecting the two, it’s just an empirical quirk, a result of transaction costs, not of interest rate.

You also leave the claim in my first post unaddressed. It’s the opposite extreme of transaction costs: if the transaction costs of specie is sufficiently low, then credit will never be accepted as a medium of exchange, and the system would result in a completely different equilibrium. A potential empirical example of this is Bitcoin.

How can equilibria in a system where the money supply is only credit and where the money supply is only specie, and all the steps in between, all be macroeconomically optimal? They can’t. They result in a completely different outcomes with respect to the money supply. On the microeconomic level it’s even worse, since the distribution of the money supply is different too.

What creates the boundary for uninhibited hyperinflation through credit expansion is the convertibility to the monetary base. It’s not the interest rate.

“My own view is that the natural interest rate is inherently unobservable and there is no guarantee that pure market forces would always cause the natural rate to correspond to the market rate, in the absence of any central bank intervention.”

I believe, on the contrary, that it is owing mainly to the intervention of central banks–or rather to their very existence, as they cannot help “intervening” regardless of what stance they take–that market rates frequently diverge substantially from natural ones. In The Theory of Free Banking I discuss in some detail the determinants of monetary expansion under free banking, and show how, under certain conditions, those determinants lead to a money stock that adjusts precisely as it ought to to avoid short-run monetary disequilibrium and corresponding unnatural interest rates changes.

Moreover, any reference to the implications of “pure market forces” that takes the presence of central banks for granted is self-contradictory. Let’s not blame markets for the machinations of central bankers, or confuse regulation of money and credit by market forces with what happens in a central bank regime in which the central bank pretends to play a passive part. A market-based money supply process isn’t the same as a central bank based one in which the central bank does not attempt to engage in counter-cyclical policy!

Yeah, sure, you can have reduction in money supply (relative to trend) without a prior boom. Whoever denied it? Indeed, I’ve been citing Friedman & Schwartz’s diagnosis of the Great Contraction on this thread. So, yes, you can have bust without a prior boom. Hence my repeated references to F&S and my remark in my first comment in this thread: “And I do think the difference between ABCT and the monetary disequilibrium theory have been exaggerated by many of us in the ‘Austrian’ group.”

Very briefly on the Fisher 1907 thing: I’m just saying that maybe it took some time for the idea to catch on and become commonplace, plus maybe the link between NPV and time-structure of production was not obvious. In some sense I suppose we are really talking about Macauly duration, and I think that goes back only to 1938, which would be after Hayek’s two main statements of ABCT.

Referring to Roger’s comment above: one of the most destructive tendencies I see in the exchanges between Austrians and monetarists, both in connection with the recent cycle and in connection with that of 1924-33, has been the tendency of monetarists to paint those who take the Austrian boom bust theory seriously as necessarily denying that monetary (that is, MV) contraction is also depressing. That unwarranted charge has, for example, been launched at me several times since I posted my (really very qualified) defense of the ABCT.

Monetarists and other critics of the ABCT need to cut it out. By changing an argument for the damaging consequences of unsustainable booms into one denying the dangerous consequences of spending collapses, you score cheap points against a theory without really confronting it. And that remains true even if it is indeed the case 9which in fact it is) that some ABCT proponents do in fact argue as if there was no reason to regard spending collapses as harmful.

I don’t think, David, that you have been particularly to blame of the fault in question, by the way: you do occasionally lapse into it, but you also concede that the Austrian view ultimately stands or falls on the strength of empirical evidence supporting it. That latter view is surely the right one.

But there are multiple value schema’s in real life. For instance gold is valued because of its electrical properties (utilitarian), because of its corrosion resistant properties (utilitarian), because of its appearance (ephemeral – luxury), and because it once was used as a medium of exchange (ephemeral – nostalgic).

Some of those properties are a function of gold being a limited resource and others are a function of gold being a desired asset. And so while Austrians may only see the lump sum value of gold as relevant, the composition of value has some profound macro-economic effects.

Mr. Restly, I have been a student of Austrian school economics for many years; I have studied under some of its leading lights; I have read it’s principle works from Menger onwards (and many lesser ones as well). And for the life of me, I cannot detect anything in your statements concerning it that suggests that you are in fact familiar with the theory of value for which it and its founder in particular are famous–a theory that is, after all, the basis (along with contemporaneous contributions of Walras, Jevons, and Marshall) for all of modern value theory.

In a previous post I note that you expressed befuddlement at being referred to the notion of the “demand for real money balances”–this while expostulating on Mises’ monetary theory. As a monetary economist myself, I also am in a position to declare that it is practically as impossible to make coherent, let alone sensible, arguments about monetary economics and policy without a grasp of that notion as it would be to say sensible things about physics without grasping the meaning of the term “force.”

In short, Mr. Restly, I wonder at the temerity with which you opine about various subjects concerning which you appear to be only dimly informed. .

I opine with temerity because I am dimly informed. I am just a regular guy looking for answers. I am not an economist by trade and never claimed to be. If I write things that seem uninformed, or unenlightened, so be it. I am not ashamed of what I don’t know, and I really don’t care if it shows.

Peter, I am not aware of any contradiction. My position is that differences in transactions costs associated with alternative monetary instruments are among the factors that determine how much of a particular instrument people will choose to hold. But that is not the only factor.

Different systems and different historical situations involve different relationships between transactions costs and the relative costs and returns of holding different monetary instruments. I don’t see any necessary relationship that must obtain under all circumstances, so I am not really don’t see how you arrive at the conclusion that specie dominates all other monetary instruments.

George, I agree that, under certain conditions, a free banking system could ensure the optimal behavior of the money supply and market interest rates. I think that we probably disagree on what those conditions are, and I am also not so sure you or I or anyone really knows what conditions would be necessary.

Roger, So are there any modern expositions of ABCT that are expressed in terms of the Fisherian theory of capital and interest?

George, In fact I have pointed out on many occasions that Hayek recognized the point. However, it is also fair to point out that notwithstanding the theoretical recognition that a decline in spending could have damaging consequences, Hayek and other ABCT theorists gave the wrong policy advice during the Great Depression.

I have a monograph under review now that gives my take. I’m not sure how Fisherian I am in the MS, nor what, like, your criteria are for being Fisherian. But I do say explicitly that the sectoral shifts are just a matter of interest sensitivity. I don’t think I mentioned duration, but I still kind think we might import that construct. I think existing expositions (including Horwitz if I recall correctly) do still tend to use Hayekian triangles and “Austrian” notions of the time structure of production rather than cutting the Gordian knot with duration or just “interest sensitivity.”

as long as you admit that transaction costs have a non-zero effect on the decision to depositing money into the bank, you contradict your other opinion that the demand holding credit instruments creates an equilibrium of the money supply. You equate the deposits with money, but simultaneously admit that transaction costs influence the relationship between money and deposits. These assumptions cannot be simultaneously valid.

In order to fix the contradictions, at least one of the assumptions needs to go. Either deposits are automatically money, irrespective of whether people use them as a medium of exchange, or the credit expansion/contraction process does not create an equilibrium of the money supply. I’ll leave it up to you which way to go.

You don’t need to agree with me that transaction costs are the only reason why people use an instrument issued by the bank as a medium of exchange. Maybe that’s a too big jump for you, so I’m not pushing on that.

Roger, Your monograph sounds very interesting and may be a way to cut through some of the intractable disputes that weigh down debates about ABCT. So good luck with it and I look forward to reading it in the future.

Peter, I am sorry, but I am just not following the logic of your argument.

As long as you admit that transaction costs influence whether a bank deposit is or isn’t a part of the money supply, the withdrawing/depositing mechanism cannot equilibrate the money supply. This is elementary logic.

If, on one extreme, demand deposit does not act as a part of the money supply, then the effect of depositing/withdrawing on the money supply does not exist. If on the other extreme noone uses base money in transactions, then there is no reason to withdrawal money whatsoever, irrespective of the interest rate. Selgin even admits this indirectly, in one of his speeches I believe he said that even if there historically was a bank run, people immediately deposited the withdrawn money into another bank.

So not only is the allegedly equilibrating mechanism you and Selgin ascribe to the demand deposits NOT equilibrating, in the extremes it does not exist at all.

About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.